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Tuesday, March 08, 2011

Currently rereading Jack Schwager's Stock Market Wizards and I came across a very illuminating excerpt from an interview with short-seller, Dana Galante.

Had you read Galante's interview back in 2000, especially her comments on the value of auditing firms and the discretion banks and fund managers had in valuing illiquid investments, you might not have been surprised by subsequent events in our capital markets (read: Enron, Arthur Andersen, The Financial Crisis of 2007-2009, and so on).

Here's an excerpt from Schwager's chat with Galante in which she explains how a former boss was hiding trading losses from investors by marking up the value of illiquid private company investments in the fund's portfolio:

"JS: It almost sounds as if he was gambling with the portfolio.

DG: It sure appeared to be gambling. Looking back, it seemed that he tried to hide these losses by marking up the prices on privately held stock in his portfolio. He had complete discretion on pricing these positions.

How was he able to value these positions wherever he wanted to?

Because they were privately held companies; there was no publicly traded stock.

Is it legal to price privately held stocks with such broad discretion?

Yes. In respect to private companies, the general partner is given that discretion in the hedge fund disclosure document. The auditors also bought off on these numbers every year. He would tell them what he thought these companies were worth and why, and they would accept his valuations. They were these twenty-two-year-old auditors just out of college, and he was the hedge fund manager making $20 million a year; they weren't about to question him.

Another hedge fund manager I interviewed who also does a lot of short selling said that the value of audits on a scale of 0 to 100 was zero. Do you agree?

Yes.

Even if it's a leading accounting firm?

Oh yeah."

Now this type of exchange may not come as a surprise to readers in 2011, but I can assure you that plenty of people were shocked and caught unaware by these realities back in 2001-2003 and once again during the recent financial crisis.

So I guess the moral of the story is, do your own thinking and don't rely on the word of prestigious auditing firms and conflicted ratings agencies. Always do your own homework and try to understand how "business as usual" at the supposed safeguard firms can lead to disastrous results for those caught unaware.